Analysis

Who Will Cover the Cost of the Budget Crunch? Not Israel’s Biggest Firms

The government needs to close a yawning fiscal gap, but it’s loath to tinker with the corporate tax rate at a time when Trump has cut the U.S. rate

The Ministry of Finance
Emil Salman

When a new government is finally formed it will have to make some difficult decisions quickly about the budget — namely, how to cut it and what taxes to increase. There’s simply no other way to deal with the 20 billion shekels ($5.8 billion) in overspending and above the targeted deficit level, much less to fund plans for increased defense and health spending and higher old-age allowances.

The biggest problem will be taxes. Over the past 15 years, Israel has enjoyed steadily declining tax rates, which have made an important contribution to economic growth.

One of the biggest cuts was to the corporate income tax rate, which fell to 36% today, from 23% in 2003. It was supposed to be lowered to 18%, but the 2011 social-justice protests put an end to that.

When it comes to tax hikes, the government ideally should choose the most efficient and progressive options. However, it almost certainly won’t, because the taxes that meet those powerful interest groups will come to their defense. In the end, the government will make do with what it can accomplish politically.

Could corporate taxes end up the preferred candidate? In an analysis of the corporate tax and its impact on state revenues last week, the Finance Ministry’s chief economist found that the biggest corporations pay the lowest rate of all.

Paying less.

For example, in 2016 medium and small corporations that generated profits paid an average rate of 24.7%. Big corporations – those in the top 10% — paid an average rate of just 20.6%. The top 1% paid an even lower 19.3%. That worked out to an across-the-board average of just 21% in a year when the official rate was 25%.

The reason for the difference is the Law for Encouraging Capital Investment, which grants tax benefits to exporters. These benefits go primarily to large companies and lower their effective tax rate.

The law also has the perverse impact of encouraging higher levels of innovation and productivity at exporting companies while discouraging it for others. This is not only a serious problem for the economy, but it also raises the issue of progressive taxation for businesses.

When it comes to personal income tax, the accepted formula is that the more income the payer earns the higher the rate he or she is liable for. It’s one of the government’s chief tools for reducing income inequality.

Corporate income tax, by comparison, is charged at a single rate without regard to the level of profitability of the payer. However, in practice, it’s the biggest companies that pay the lowest rates by virtue of the investment law and the ability of their accounting teams to plan their taxes better than less well-heeled firms. Thus, in the corporate world taxes are effectively regressive.

Should we care? There’s a logic behind trying to reduce income gaps between individuals, but does that same logic apply to business?

According to the chief economist of the Finance Ministry we should, because research has shown that when there are big differentials between effective corporate tax rates there are also big differences in personal tax rates.

In 2012, then-Knesset member Zehava Golan (Meretz) proposed legislation that would have lowered the corporate tax rate to 20% for companies that earned up to 1.2 million shekels annually while those earning more would pay 30%. The law intended to prevent the most profitable companies from paying too little in taxes.

Four years earlier it was revealed that the four biggest companies in Israel — Intel Israel, Teva Pharmaceutical Industries, Iscar and Israel Chemicals — had enjoyed combined tax exemptions of 3.6 billion shekels. That accounted for three-quarters of all the exemptions granted that year As a result, the effective corporate tax rate had been just 7.2%. Again, it was the investment law that allowed that to happen, especially in the cases of Intel and Teva.

It might be too much to expect that fairness be a guiding principle for the corporate tax regime, but it would be fair to ask whether the system is effective.

Israel grants tax benefits to the biggest companies because they employ so many people. They can choose to invest in new factories and other facilities overseas because they have the logistical resources to do so. Their success or failure can be seen quickly and easily in the wider economy through exports and employment figures. They also employ lobbyists.

In any case, any effort to raise the corporate tax in Israel faces the challenge set by U.S. President Donald Trump. His led the December 2017 legislation that lowered U.S. corporate taxes from a top rate of 35% to 21%. That has raised fears throughout the world of companies moving their operations to the United States in order to save on taxes.

In Israel, those worries weren’t too big because high-tech companies and exporters are given special tax treatment via the investment law. The result is that Israel’s tax regime doesn’t help companies that need lower rates but companies that could pick and go if they want.

Maybe Israel doesn’t need small and medium-sized companies, which not only pay higher taxes but contend with more red tape than their bigger peers? The answer is no, it does need them because they employ far more people than the big four. However, even if a smaller business could move its operations overseas, it wouldn’t show up the national accounts; at most, it would hurt one small locality’s employment rate.

If there is no chance of reforming the investment law, the Tax Authority could still collect more tax from the most profitable companies and make Israeli corporate tax rates more progressive. Inquiries with the authority revealed nothing like that is on the agenda because the taxmen dislike differential corporate rates. The biggest companies could engage in the most sophisticated tax planning, moving income and expenses between subsidies or from one year to the next. Differential rates would probably end up producing lower revenues for the government. This is the same case that the opponents of a wealth tax are making: The rich will find ways to evade it, so don’t even try.

However, the treasury’s chief economist offers several ways lower rates for smaller businesses would benefit the economy. Among other things, it would encourage them more to hire more people than lower rates do for big businesses. Smaller companies are more likely to hire inexperienced workers and provide training as well as employ women, the disabled and minorities.

Of the 36 countries that belong to the Organization for Economic Cooperation and Development, 10 have progressive corporate taxation policies.

Corporate taxes are the third-largest source of state revenue in Israel, after the value-added tax and personal income taxes. Last year they accounted for 43 billion shekels of government revenue, 13.4% of the total.

However, between the Trump tax cut is, the U.S.-China trade war and Brexit, Israel’s Finance Ministry is less inclined than ever to touch the local corporate tax rate. Tinkering with the rate could take a toll on economic growth very quickly. If so, the Israeli public should get ready for the tax hikes to hit them directly in their pocketbooks through hikes in VAT and in health insurance contributions.